Understanding important income-tax terms

Question: Can you please explain some tax terms for me, including taxable income and marginal tax rate?

Answer: Your taxable income is different from the total amount of money you earn during the tax year from employment and investments. Taxable income is defined as the amount of income on which you actually pay income taxes. You don’t pay taxes on your total income for the following two reasons:

Not all income is taxable. For example, you pay federal income tax on the interest that you earn on a bank savings account but not on the interest from municipal bonds.

You get to subtract deductions from your income. For tax year 2013, single people receive an automatic $6,100 standard deduction, heads of household qualify for $8,950, and married couples filing jointly get $12,200. (People older than 65 and those who are blind get slightly higher deductions.) Other expenses, such as mortgage interest and property taxes, are deductible to the extent that your total itemized deductions exceed the standard deductions.

Marginal is a word that people often use when they mean “small” or “barely acceptable.” But with taxes, marginal has a different meaning.

The government charges you different income-tax rates for different portions of your annual income. So your marginal tax rate is the rate that you pay on the so-called last dollars you earn. You generally pay less tax on your first, or lowest, dollars of earnings and more tax on your last, or highest, dollars of earnings. This system is known as a graduated income tax.

The fact that not all income is treated equally under the current tax system isn’t evident to most people. When you work for an employer and have a reasonably constant salary during the course of a year, a stable amount of federal and state taxes is deducted from each of your paychecks. Therefore, you may have the false impression that all your earned income is taxed equally.

Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of taxable income.

For example, if you’re single and your taxable income during 2013 totals $50,000, you pay federal income tax at the rate of 10 percent on the first $8,925 of taxable income. You then pay 15 percent on the amount from $8,925 to $36,250, and 25 percent on income from $36,250 up to $50,000.

In other words, you effectively pay a marginal federal tax rate of 25 percent on your last dollars of income — those dollars in excess of $36,250.

After you understand the powerful concept of marginal tax rates, you can see the value of the many financial strategies that affect the amount of taxes you pay. Because you pay taxes on your employment income and your investment earnings, you need to make many of your personal financial decisions with your marginal tax rate in mind.

For example, when you have the opportunity to earn some extra money, how much of that extra compensation you get to keep depends on your marginal tax rate. Your marginal income tax rate enables you to quickly calculate the additional taxes you’d pay on the additional income.

Conversely, you quantify the amount of taxes that you save by reducing your taxable income, either by decreasing your income, for example, with pretax contributions to retirement accounts or by increasing your deductions.

Your federal income tax rates can effectively be higher than the official federal income tax brackets because some tax breaks are reduced when your income exceeds a particular level. For example:

Itemized deductions, which are recorded on Schedule A, are reduced for tax year 2013 when your adjusted gross income exceeds $250,000 ($300,000 for married people filing separately).

Personal exemptions are a freebie — they’re a write-off of $3,900 in tax year 2013 just because you’re a living, breathing human being. However, personal exemptions are whittled away for single-income earners with AGIs of more than $250,000, married people filing jointly with AGIs of more than $300,000, and married people filing separately with AGIs of more than $150,000.

Your eligibility to fully contribute to Roth Individual Retirement Accounts depends on your AGI being less than or equal to $112,000 if you’re a single taxpayer or $178,000 if you’re married. Beyond these amounts, allowable contributions are phased out.

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